What's the Word? Reversification

"When I use a word," Humpty Dumpty said, in a rather scornful tone, "it means just what I choose it to mean—neither more nor less."

"The question is," said Alice, "whether you can make words mean so many different things."

"The question is," said Humpty Dumpty, "which is to be master -- that's all."

Not only Alice in Wonderland but also economics and finance have developed their own vocabulary. Terms that constitute a convenient shorthand for insiders often serve mainly to obfuscate their true meaning to everybody else. Indeed, that often seems to be the intent.

John Lanchester asserts as much about financial terms in a piece in the current New Yorker, "Money Talks." Words are twisted to mean what the masters of the financial universe intend, to the befuddlement of everyone else.

He calls this "reversification," a process that twists words to the opposite of their true meaning. Bail out, a nautical term to "slop water over the side of a boat," comes to mean "the injection of public money into a failing institution," he writes. One may counter that the colloquial meaning of bail out is to rescue, as in someone stuck in the hoosegow having bail posted.

That quibble aside, Lanchester asserts that credit has been reversified into debt; inflation means money is worth less; synergy means sacking people; risk means a "precise mathematical assessment of probability," and noncore assets mean "garbage." Fair enough, especially given that the academic definition of risk is volatility of prices, regardless of direction, when average folks think of risk as the chance of losing money.

One financial term not addressed by the New Yorker essay is "correction," one that I've found fascinating and befuddling. The notion that securities prices are incorrect one day and correct the next is rather mind-boggling. Do we all collectively experience a revelation like Saul on the road to Damascus? It is more likely, because prices are set on the margin -- economics jargon meaning that the last buyer and seller establish the price that applies to everybody -- that short-term price swings are a result of actions by the most excitable traders in the market, and thus tend to be so much noise.

By convention, if not by strict definition, a correction is a decline of 10%. Why? A bear market is a 20% drop, so a loss only half as big means a midcourse correction in the bull trend. Besides, as the late William Safire archly observed in his On Language column in the New York Times back in 2007, correction was "chosen over 'nosedive,' 'plunge,' 'falling out of bed,' and other alarmist terms."

Thursday's stock market action seemed more than a bit alarming, with the Dow Jones Industrial Average plunging over 300 points, which put it back in negative territory for 2014. That the market could become so unhinged so quickly was all the more of a surprise, given the array of global risks it has faced this year with equanimity, or some might say, complacency: concerns about China's banking system; the ISIS insurgency in Iraq; the conflict in Ukraine and the downing of the Malaysian airliner, with the tightening of sanctions on Russia; and the Gaza crisis, to name just the most prominent parts of this world of woe. Excluded from the list is the latest default by Argentina since, like the Chicago Cubs, anybody can have a bad century.

The travails of the bulls seem to lie closer to home -- that the inevitable day when they would have to bid farewell to their BFF, the near-zero interest rates engineered by the Federal Reserve, may be drawing closer. That's because the Fed may be able to unfurl the "Mission Accomplished" banner on its goals of boosting employment and bringing inflation in line with its target.

The strongest sign of that came in Thursday morning's report of a 0.7% quarterly increase in the employment-cost index for the second quarter, substantially greater than the median forecast of a 0.5% rise and more than twice as much as the first quarter's 0.3% uptick. The latest quarter saw a 0.6% gain in wages and salaries, combined with a 1% jump in the cost of benefits. In other words, American workers were getting raises, a sure sign of a better labor market.

That followed news on Wednesday morning of a 4% annualized expansion in gross domestic product in the second quarter, a sharp rebound from the revised 2.1% yearly pace of contraction during the weather-affected first quarter, a better-than-expected showing. There could be some quibbles that the GDP report overstates the second-quarter recovery because it was boosted by inventory accumulation. Excluding that factor, final sales expanded at a 2.3% annual rate, up from a negative 1% in the first quarter, but roughly in line with a 2% year-on-year pace of expansion.

The import of these numbers is their juxtaposition to the words coming out of the Federal Open Market Committee on Wednesday. The Federal Reserve's policy-setting panel acknowledged both that inflation had "moved somewhat closer to its longer-run objective" of 2% and that "labor market conditions improved, with the unemployment rate declining further," which was considerably more optimistic verbiage on both counts than previous statements.

The FOMC, as expected, trimmed its monthly asset purchases by another $10 billion, to $25 billion, continuing the glide path to ending its bond buying by October. The panel also reaffirmed its intent to maintain near-zero short-term rates -- which have been in place since the depths of crisis in December 2008 -- for a "considerable time." That elicited a dissent from Philadelphia Fed President Charles Plosser, who objected to a time plan given the economy's improvement.

The violent reaction on Thursday -- which wasn't confined to the U.S. stock market, but also extended to other asset classes, notably high-yield bonds -- suggests a re-emergence of what the New Yorker's Lanchester might categorize as reversification. That is, the good news is bad news for securities prices, stocks, and bonds alike.

Good news on the economy brings forward that day when interest rates move from an irreducible minimum to a merely low level. Federal-funds futures contracts project an overnight money rate of just 0.75% by December 2015, up from the Fed's current 0%-0.25% target. By the end of 2016, the futures market sees a funds rate of 1.75%.

Relative to the Fed's current stance, that constitutes a tightening -- not merely a small correction of current abnormal conditions. All of which indicates how dependent on language distortion asset markets have become.

THE KEY WORD FOR FED POLICY may be "slack." In common usage, it refers to tension, as on a rope. But in this case, it is economists' description for spare capacity in the labor market -- the number of available, employable workers, compared with the number of job openings. I revert to Karl Marx's far more colorful metaphor of "the reserve army of unemployed" who are ready, willing, and able to go to work when called, rather than referring to slack, but it's the same thing.

Fed Chair Janet Yellen's avowed aim is to haul in the slack in the labor market by promoting growth with the same ultra-easy monetary policy that has inflated asset prices. (Note to Lanchester: Inflation balloons the prices of stuff while it shrinks the value of money.)

Tightening that slack means not just expanding employment, but also rising wages. July's employment report, released on Friday, showed further jobs gains, but little in the way of pay raises. Nonfarm payrolls expanded by 209,000, trivially less than the 230,000 consensus forecast, and below the upwardly revised 298,000 jump in June, originally estimated at 288,000. The separate survey of households showed a slight uptick in the headline jobless rate, to 6.2% from 6.1%, but that reflected a similar rise in the long depressed labor-force participation rate.

But that dreaded slack was evident elsewhere. JPMorgan's chief U.S. economist, Michael Feroli, noted that the number of those with part-time jobs for economic reasons remains high, while "discouraged" workers (those who have stopped pounding the pavement) increased last month. Moreover, average hourly earnings were flat and up just 2% in the past year, leaving working folks running in place after inflation.

As Paul McCulley, who recently returned to Pimco as chief economist, writes, "[Fed] Chair Yellen wants labor to get a fairer share of the fruits of the economy's productivity: nominal wage gains greater than inflation -- real wage gains."

The July jobs report suggests that hasn't happened yet, so stocks' slide slowed on Friday. Still, the major stock market indexes lost 2.7% on the week, lightening investors' portfolios by some $650 billion, by Wilshire Associates' reckoning.

Moreover, the August issue of the Bank Credit Analyst contends that, while much of the financial community thinks the Fed is "behind the curve" (to use more jargon) in tightening policy, there also are risks of hiking rates too early and by too much. BCA further suggests that the "neutral" fed-funds rate -- the interest rate that neither stomps on the gas nor hits the brakes on the economy, if another metaphor is permitted -- likely is lower than previously thought. That is similar to Pimco's "New Neutral" hypothesis.

What does it all mean in words and numbers? A neutral fed-funds rate that allows the economy to motor at cruising speed may be about 2%, not 4% as in the past, for a variety of reasons. But just the prospect of 1% short-term rates next year seemed to spook asset markets last week. What's the word to describe the notion that capital markets are dependent on the cheap money intended to boost wages for labor?

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